Readers who have been following my column for some time will know I intended to design a new portfolio for July 1. I can now report ‘Mission accomplished’. On Wednesday, Thursday and Friday last week, I bought 16 stocks that I did not already own – but I had previously owned three of them a few years ago.
I will be writing over the next few months about how I made various decisions. But, at the outset, I want to stress that it took me six months of hard work to come to this new framework after a lengthy career in markets.
The process
Since most of the stocks were new to me, and I think resources stocks might have a good run over the next few months, I didn’t sell down my whole portfolio to cash so as to buy the new one. Rather, I sold 25% (approximately) a few weeks ago, basing my selling decisions on those sectors I judged to be overpriced using my exuberance measure. As it turns out, I sold six of the eight parcels of shares at prices above today’s prices and the other (AGK) did fall but is now a few cents higher following a recent regulatory decision. That means I did not lose by being in cash for about a month. I like to record all of these sorts of actions so I can learn when I make poor decisions!
About every three months I will sell down about 25% of the old portfolio and invest in the (possibly rebalanced) portfolio. Obviously the conditions at the time will have to be right for me and a lot can happen in a few months.
The first decision to make – in my book – is to articulate the objectives for the portfolio. I want to end up with a yield of about 8% (including franking credits) if that is possible. That means I can draw down my pension only from dividends rather than having to sell for capital gains. Under the current pension rules for minimum drawdown, the 8%will be above the minimum for the next 20 years (for me). By the time I am 85 (if I make it), I might be starting to look for some sort of aged care and my slowly growing capital should see me OK.
Better than the banks
The classic way to build a vanilla portfolio is to buy the four big banks, Telstra, a property trust or two and weight them equally. I think I can do better than that – but there is nothing wrong with that approach for investors who are comfortable with it. This new portfolio of mine was designed only for me and it may not suit others. Nevertheless, the decisions that need to be made are common to many types of portfolios. It is just that different choices may be made at each step.
So I want some growth as well as yield. I do not see much growth in the classic portfolio that I just mentioned, as dividends have been compressed down to low – but sustainable – levels. My portfolio ‘style’ affects the sector weights or loadings I use, the number of stocks I choose, and the companies in which I invest – and the stock weights within sectors.
Let’s start with the sector weights. For simplicity (and privacy) I am assuming that I have $100,000 to invest and that does not include brokerage and any other transaction costs. I have set out in Table 1 where that money would be invested if I wanted to hug the ASX 200 index – under the heading ‘Index’. These amounts change over time as component stocks change in price and stocks enter or leave the index.
Allocations of a $100,000 portfolio under two scenarios
Source: Thomson Reuters Datastream & Woodhall Investment Research. As at 25 June 2014.
So an index-hugger would buy $6,029 of stocks from the energy sector, $39,222 worth of banks and related stocks, etc. Obviously allocations cannot be exact but one can usually get pretty close. I trade on CommSec and find their calculator useful in terms of deciding how many of each stock I want. But a word of caution, I nearly made a couple of silly mistakes when trying to by 16 stocks in three days. It is so important to write down the value, the number of stocks and the price by your calculations – and double check the stock codes!
The tilts
Since I want a yield portfolio, it makes sense to invest more in the high-yielding sectors and less in the resources and others sectors. This process is called tilting. It can be done by just using common sense or highly sophisticated optimisation techniques can be used. The simplest solution would be to put zero dollars in the seven non-high yield sectors and scale up the others in proportion i.e. one might place $74,622 in financials, $12,117 in property, $10,041 in telcos and $3,220 in utilities.
The simple four-sector approach does not have much in the way of diversification or growth benefits. I use a very complex method based on my massaging of broker forecasts of dividends and earnings, and risk forecasts from daily index price changes. Rather than trying to just achieve the highest ‘risk-adjusted return’ – or the so-called Sharpe ratio – I put limits on the tilts to achieve my hybrid yield-growth goals. For example, I do not allow the four high-yielding sectors to be ‘underweight’. That is, I must have at least $39,222 in Financials, etc. – but the optimiser might choose more.
I show the weights I used as a base in my trades under the column headed ‘Tilts’. These weights do change from month to month as expected risk and returns evolve – and sometimes they evolve quickly – so beware! Although these weights were my base, I changed them for reasons I will give in the next few weeks.
So, under the ‘tilt’ heading in Table 1, one can note Materials and IT each got no allocation because of the poor expected returns and high risk. Financials got index-weight but the other three high-yield sectors are overweight. Next time I will discuss how many stocks to choose in each sector and the stocks that passed my ‘filters’.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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